In 2022, an emerging sector of the crypto industry known as decentralized finance, popularly known as DeFi, raised $2.71 billion in venture capital funding. Many investors saw the sector as the future, a technological revolution that would make financial services more democratic and accessible to everyone.
DeFi remains popular, even if the crypto market rout of 2022 saw investment decrease dramatically. Its unique selling proposition is a decentralized spin on financial services traditionally offered by banks, like loans and derivatives. The difference is that DeFi alternatives require no actual “banks” to oversee the use of these instruments.
Rather, DeFi is powered by smart contracts—pieces of self-executing code built on blockchain technology that let users settle financial agreements automatically and “trustlessly”—that is, without the mediation of a third party.
Though the possibilities of DeFi are still being worked out, much of the excitement around the technology revolves around its promise that users can “be their own bank.”
The idea is that rather than needing permission to access financial services from traditional institutions, DeFi lets anyone, anywhere, access trade and funding as easily as they can search for information on the internet.
Let’s dig into three core innovations within DeFi thus far: lending protocols, decentralized exchanges, and yield farming.
1. Lending and Borrowing
Certain DeFi protocols let users securely borrow money without needing credit or a bank account. Instead, they use smart contracts to transparently establish lending terms between two parties, and carry out the terms when certain conditions are met.
The Aave protocol, for instance, lets users borrow cryptocurrency using another cryptocurrency—one that’s greater than the value of the loan—as collateral.
Loans must be overcollateralized due to the price volatility of most cryptocurrencies. If the value of one’s crypto collateral drops below a certain value-to-loan ratio, then the loan will be liquidated.
Many DeFi protocols, including Aave, let users borrow and lend using stablecoins—cryptocurrencies that are price-pegged to fiat currencies, such as USD. The two largest stablecoin assets—Tether (USDT) and USD Coin (USDC)—back their stablecoins using reserves filled with US Treasuries and cash. (In the case of Tether, that mix also includes a controversial cocktail of commercial paper and secured loans.)
Naturally, a lending protocol requires a large pool of liquidity to serve its customer base. That’s why Aave lets users lend out their own crypto as well, depositing their funds into the protocol’s various liquidity pools in return for interest that is paid by borrowers. In other words, borrowers effectively get their loans from other network users, rather than a bank.
As of April 2023, over $8.3 billion of liquidity was locked across 11 markets on Aave.
2. Decentralized Exchanges
A decentralized exchange (DEX) lets users directly swap one cryptocurrency for another using smart contracts, without needing to deposit their coins with a third-party. By comparison, accessing stock market investments in the traditional financial world normally requires having a bank account to store your fiat money—an account that could be frozen or restricted at any time.
Uniswap, one of the top DEXes, lets users buy and sell over 930 cryptocurrencies and non-fungible tokens (NFTs). Alternatively, users can deposit their crypto into the protocol’s liquidity pools and earn fees on swaps.
The first (and still most dominant) means of conveniently buying and selling cryptocurrency was to use centralized exchanges like Binance or Coinbase. These exchanges hold users’ fiat money and cryptocurrency under their control during trades, trusting the exchange to keep those funds safe.
Centralized exchanges may run the risk of being hacked (e.g., Mt. Gox) or misappropriating customers’ funds (e.g., FTX), resulting in lost assets and failed businesses. They may also be barred from certain jurisdictions and often implement know-your-customer (KYC) checks that collect personal data of their customers.
By contrast, DEXes are accessible by anyone with an internet connection and are as anonymous as a user’s crypto address. Most importantly, DEXes can be accessed directly from a user’s personal wallet, meaning they stay in full control of their funds at all times.
Uniswap is currently integrated with many popular crypto wallets, including Coinbase Wallet and MetaMask.
3. Yield Farming
Yield farming is the practice of depositing one’s crypto into DeFi liquidity pools in order to earn yield. A liquidity pool is a large pool of crypto assets locked away and ready to provide liquidity for decentralized trading services. These include liquidity pools for DEX and lending protocols, such as Aave and Uniswap.Yearn.Finance is a popular yield farming tool designed to help investors automate their cryptocurrency investments and easily locate the liquidity pools offering the highest yield. There was over $440 million locked within the protocol as of April 2023, having boasted $6 billion at its peak in November 2021.
The protocol aggregates liquidity pools across various DeFi protocols—such as Aave and Compound—and automatically moves user funds between them to earn the best rates. That rate is expressed as an annual percentage yield (APY), which generally decreases as more people add liquidity to the pool.
Each protocol can earn yield in different ways: Aave pools generate yield using interest paid by borrowers, while Compound pays out its liquidity providers with its native COMP governance token.
Problems Facing DeFi
Decentralized finance is not without its issues. While smart contract code is theoretically transparent and infallible, the humans who write it are most certainly not. Hacks and thefts of DeFi protocols have become something of a recurring theme, as hackers regularly exploit holes in smart contract code to steal millions of dollars from users.
Over $3 billion was lost to DeFi hackers in 2022—much of which came from contracts with code that were already audited.
Sometimes, DeFi projects are undone by the Byzantine algorithmic mechanisms that underpin them. In May 2022, the formerly third-largest stablecoin, TerraUSD (UST), lost its near $10 billion market cap as its flawed decentralized peg system fell apart. The “stable” coin’s price has since collapsed from $1 at the time to just $0.02 as of April 2023.
What’s in Store for DeFi?
New use cases continue to emerge within the DeFi space, with the aim of providing a wider array of financial services in a permissionless and trustless manner.
Protocols like Nexus Mutual, for instance, are providing decentralized, community-owned insurance against the various risks present in other areas of DeFi, including custodian hacks, token-depegs, and halted withdrawals. Meanwhile, projects like Azuro have created decentralized prediction markets for real-world events.
Other, wackier innovations include “flash loans,” a flagship Aave technology that lets traders originate huge loans instantaneously without collateral. The catch is that the borrower has to pay the loan back within the same blockchain “block” in which it is transferred. If the loan isn’t repaid by the block’s completion, the loan is annulled, and the money returned. That allows canny investors to profit from instant spikes in volatile crypto assets without risk—they either profit, or the loan essentially never took place.
On the regulatory front, DeFi may face significant challenges and restrictions from regulators and an increasingly cautious US Treasury Department. The agency published a report in April 2023 outlining risks that DeFi presents to national security, and potential ways to address them.
DeFi, however, remains stubbornly popular among crypto investors. Though the successive market downturns of 2022 saw the “total value locked”—that is, the amount of money deposited in DeFi contracts—fall from a high of around $178 billion to around $45 billion, that figure has since been steadily recovering. Indeed, following the implosion of the highly centralized FTX exchange, investors are looking to DeFi as a more secure model of cryptocurrency ownership. For all the risks involved, it may still be safer to be one’s own bank—at least in the treacherous crypto world.